The dividend payout policy is most deliberate topic within finance field and some academic have called the company's dividend payout policy an unsettled puzzle. Dividend payout policy has prospective roles to be considered as part of the firm's strength to operate efficiently in the corporate world. Profitability and other factors has significant impact on dividend. It becomes an important issue for firms to identify the factors determining dividend payout policy. The purpose of the study is to determine if there is a relationship between a numbers of company selected factors and the companies' dividend payout. Profitability is primary indicator of dividend payout ratio. There are also other factors that affect dividend policy such as cash flows, size, growth in sales and market to book value. this research shows that dividend payout policy is positively related to profits, cash flows and have negtiave relationship with taxes, sales growth and market to book value. This study also explains four dividend theories that are irrelevance theory, the bird in the hand theory, the signaling theory and the agency cost theory. The result of these theories indicate that dividend related directly size and profitability of firm and indirectly to the leverage. Above results shows that dividend payment reduces agency cost otherwise it affects firm repute and profitbility of firm. The data used in this research is collected from 2004-2010.
Introduction:
"The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don't fit together."
The policy a company uses to decide how much it will pay out to shareholders in dividends or amount of a dividend that a publicly traded company decides to pay out to shareholders. Dividend policy can be of two types: managed and residual. The residual dividend policy is the amount that left after making investment.By paying dividend value of share increases thta's why managers should adopt best policies.Dividend policy maximizes the stock price that maximize firm value. Dividend decisions are debatable issue whether or not it contributes to the value of firm. There are three types of dividend such as cash dividend, stock split and stock dividend. Cash dividend has some extensions like Regular cash dividend is cash payments made directly to stockholders usually each quarter. Extra cash dividend is sign that the extra amount may not be repeated in the future. Special cash dividend is similar to extra dividend but certainly will not be repeated. Liquidating dividend is some or all of the business has been sold. There is an alternative of cash dividend that is stock repurchase; Company buys back its own shares of stock. Tender offer is company states a purchase price and a desired number of shares. Open market is buys stock in the open market. Similar to a cash dividend in that it returns cash from the firm to the stockholders. Stock dividend is retained earnings transferred to par value and capital accounts. Stock split is par value adjusted to reflect the split with no effect on retained earnings.
This is another argument for dividend policy irrelevance in the absence of taxes or other imperfections. The question arises in mind is dividend matter or not? Its answer is future dividends.MM theory suggests dividend policy does not effect onperformance of firm as discussed in Dividend clientele, signaling approach. The question about perfect capital market broadly debated and most powerful argument towards the impact of dividends was presented by Modigliani and Miller (1961), stated that under perfect capital markets without any taxes, transaction costs and other market imperfections the company value is independent of the dividend policy. Instead the firm value is solely depended of the earning power of the company assets and its investment policy and how its profits are distributed to shareholders. If this would happen no companies would pay dividends since it does not create any additional value for the shareholders and no further research regarding dividends would be necessary. This is opposite to the view of Brawley (2008 ) who has written in undergraduate textbooks in corporate finance, he narrate that the dividend payout argument is unsolved problems in corporate finance and further research within the area is critical and we have to increase understanding about it.Free cash flow will be used as it reveals the amount of cash that is available for shareholders and creditors after all expenses has been paid. Previous studies concluded that free there is positive relation between free cash flow and dividend payout ratio and this can be explained by the agency theory of free cash flow. Jensen (1896) concluded that companies that have high free cash flow have to pay higher dividends to reduce the agency conflict between managers and shareholders. Another factor is the growth rate of the company. Several studies (Josef 1982), (Lloyd 1985), (Holder 1998) have concluded that there is a negative relationship between the growth rate of the company and the dividend payout ratio. The majority of the previous researches used growth in sales in order to measure the growth rate. In this research we will use the growth in sales in order to measure the growth rate of the company. Majority of the studies have used sales to measure growth rate and they used the data in different ways. Daunfeld (2009) used the market to book value in order to measure the growth opportunities and his finding is that a higher market to book value indicates better growth opportunities. The justification for the negative relationship between the dividend payout ratio and growth is that growing companies have to finance increased investments by retained earnings. (Josef 1982) (Lloyd 1985). Companies with lower growth rates have lower investment expenditures and higher level of retained earnings. These companies should pay high dividends in order to reduce agency cost between manager and shareholder (Jensen 1986). Leverage is the key indicators of a company's financial health it is not a normally used to test the relationship with the dividend payout ratio. Earlier studies concluded that leverage have not provided a standardized picture that shows that either leverage has an impact on the company's dividend payouts or not? Al Shabibi & Ramesh (2011) conduct a research in United Kingdom and they found no significant relationship between the leverage and the companies dividend payouts. There is contradiction between both studies made by Al Shabibi & Ramesh and Al-Kuwari (2009) who found a strong negative correlation between leverage and the dividend payout ratio. According to Werner and Jones (2003) debt to equity ratio indicate in which proportions the company is financed by creditors relative to shareholders. we decided to use the debt to equity ratio as a measurement of leverage Most earlier studies found a positive relationship between profit and the company's dividend payouts. There are also different measurements used to measure profit. Gill (2006) and Amado & Ebor (2006) used EBIT/Total assets to profit. Another method used in previous research to measure profit is the return on equity (ROE) by (Al-Kowari 2009). Al-Kowari (2009) state that ROE is one of the best measurements of the company's profit because it reveal the capacity of internally generating cash. Various studies conducted to determine the relationship between the risk of companies and the dividend payout ratio. Holder (1998) used the standard deviation of the return to measure the risk of the stock. Another study made to measure risk by using variance in cash flow (Amado & Ebor 2006. Some previous studies have used beta as a measurement of the company's market risk (Josef 1982)(Lloyd et.al (1985)(Al-Kowari 2009).
Many previous studies found that there exist strong negative relationship between the level of riskiness and dividend payout ratio (Josef 1982)(Lloyd et.al 1985). Previous studies have concluded that riskier firms have higher volatility in their cash flows which makes it more difficult to plan for future investments. This in turn contributes to that the need for external financing increases. (Josef 1982)(Al-Kowari 2009)(Al- Shubiri 2011) state the according to the pecking order theory, external financing is more expensive and companies therefore choose to decrease their dividend payouts in order to avoid more expensive external financing. Various researchers (Lloyd et.al 1985) (Holder et.al 1998) (Heidenstam & Rabble 2006) have argued that the size of the company is factors the largest influence on the dividend payout ratio. One of the first studies to incorporate the company size as a factor when determining the relationship with dividends was Lloyd et.al (1985). They argued that large firms have to pay higher dividends in order to reduce agency costs because large companies have more varied shareholders.
Overview of different theories:
"The harder we look at dividend the more it seems like a puzzle with pieces that just do not fit together".
MM theory says under perfect capital market the company's dividend payout policies do not affect the value of a company. Various researches conducted in order to test the validity of Modigliani and Miller's propositions, some accept it but not accepted by all. Black and Scholes (1974) support the results of Modigliani and Miller sand concluded that companies are capable to adjust dividend with investor tax induced preference so there exist no relation between dividend and stock return. Miller and Scholes (1978) also supports the dividend irrelevance theory and they state that tax rate for dividends and capital gains are different but do not affect the value of the company. The residual theory of dividend policy says that the firm will only pay dividends from residual earnings, earnings more than after all investment opportunities.
The Bird in the Hand Theory:
This theory conclusion is that Dividend payments affect the value of the firm and investors are willing to pay a premium price for stocks that pay dividends. A higher degree of uncertainty is connected to capital gains and dividends paid in the future compared to current capital gains and dividends. Investors use a higher discount rate in order to discount earnings for companies who not pay current dividends.
Bird in hand theory says that there is relationship between firm value and dividend payout. It states that dividends are less risky than capital gains. Investors would prefer dividends to capital gains (Amidu, 2007) as dividends are less risky than capital gains and firms should set a high dividend payout ratio and offer a high dividend yield to maximize stock price. As name of theory shows that under perfect capital markets the dividend policy is independent to the value of firm and it does not matter whether the companies have high or low dividend payouts. Modigliani and Miller theory better define capital market that is no one on the market is large enough to affect the market price of a security and everyone has access to the same costless information. In Rational behavior all actor on the market prefer more wealth to less is it does not matter whether he receives the increase in wealth in the form of capital gains from the stocks or dividend payments. Perfect certainty have the same information and know the return of every security in the future and it is possible to make the supposition that there exists only one type of security which Modigliani and Miller refer to as stocks. The bird in hand theory opposes Modigliani and Miller's dividend irrelevance theory and says that companies with higher profits pay higher dividends to its shareholders. Since this is the opposite of Modigliani and Miller's it would be interesting to test whether companies with a higher profit pay higher dividends to its shareholder. Profitability is earning generated by company, it indicate vale of firm. Dividends are important to shareholders and potential investors because they the earning generated by company. Typically managers try to keep a stable and growing dividend and do not want to decrease the dividends till it show negative signal. But in case of disaster some increase dividend and some decrease, mostly large companies decreased their dividends but other maintain it.
The signaling theory:
The explanation of signaling theory is given by Bhattacharya (1980) and John
Williams (1985) dividends disperse information asymmetric between managers and shareholders by delivering inside information of firm future prospects and dividend should be paid to shareholders according to the prices of stocks. Another argument given by Miller and Rock (1985) they state that dividends provide a signal to investors that the company's profitability will increase or decrease in near future and company growth is important determinant of the dividend payouts. The foundation of this theory lead by Lintner's (1956) study and say that the price of a company's stocks changes as the dividend payments changes. Modigliani and Miller (1961) argue in favor of the dividend irrelevance he also declared that in the real world of perfect capital markets dividend provides a "information content" which may affect the market price of the stock. Many researchers developed the signaling theory and now it is most powerful dividend theory.
Bhattacharya (1979) presented most approved study about signaling theory that is dividends play a role of signal of expected future cash flows. An increase in the dividends indicates that the managers expect higher cash flows in the future. Outside investors have flawed information about the company's future cash flows and capital gains and dividends are taxed at a higher rate as compared to capital gains. Bhattacharya (1979) argue that according to these conditions even there is a tax disadvantage for dividends, companies pay dividends to shareholder and investors in order to send positive signals.
Baker (2009) states that a company's sources of information such as accounting data and future prospect reports are not completely reliable. These kinds of information do not fully represent a company's profitable business opportunities in the future. Given that outside investors have imperfect information regarding the firm's profit opportunities, the company has to find other ways in order to convince outside investors about future cash flows and profits. Therefore positive signals such as increasing dividends provide a positive sign to outside investors. Even though dividends have a higher tax rate as compare to capital gains, investors are willing to pay a higher tax rate for dividends in exchange for the positive signal dividends send regarding that the value of the stocks. As a result of the signaling theory dividends are able to convert incompetent markets to perfect markets with full information efficiency.
Agency theory:
There are two major factors that affect the agency costs, monitoring costs and the managers risk aversion preferences. Agency costs can be concentrated by paying dividend to shareholder. The agency costs increase as the free cash flow increases and managers therefore have to pay excessive free cash flows as dividends. Jenson and Mecklings(1976) states that agency costs links with the other financial activities of a firm. Easterbrook (1984) says that firms pay out dividends in order to reduce agency costs. Dividend payout keeps firms in the capital market, where monitoring of managers is available at lower cost. If a firm has free cash flows Jensen (1986) it is better off sharing them with stockholders as dividend payout to avoid conflict between manager and shareholder and negative NPV. Easterbrook (1984) given the further explanation regarding agency cost problem and said that there are two forms of agency cost one is the cost monitoring and other on is cost of risk aversion on the part of directors or managers. Jensen states that this is due to the agency costs connected to free cash flows and shareholders prefer cash payments in the form of dividends rather than to keep the free cash flow within the company. Most powerful studies about agency costs were offered by Esterbrook(1984) obtainable another study about agency costs and his result ropes the findings made by Rozeff (1982) and Jensen (1976). Easterbrook conducted a study about dividend payments can be used in order to minimize the agency costs between managers and investors. Easterbrook state two factors affect the agency costs in a company, monitoring costs and the risk aversion preferences of managers. The monitoring cost refers to the costs incurred by the shareholders in order to supervise the managers and prevent them from following their own personal agenda instead of maximizing the value of the shareholders equity. The second source of agency costs is the risk aversion preferences of managers. The problem arises because most shareholders have diversified portfolios and they are interested in systematic risk which cannot be eliminated through diversification. In contrast to shareholders, managers usually have a large amount of their personal wealth connected to the company. Therefore if the company is unprofitable or even goes bankrupt, the managers' personal wealth becomes heavily affected. The managers will as a result be more risk averse compared to the shareholders and they may reject potential high value project due to their risk aversion preferences. According to Easterbrook (1984) these two sources of agency cost can be reduced by paying dividends to shareholders. However, Easterbrook further states that dividends are worthless in themselves and companies should therefore only pay dividends in order to reduce agency conflicts. Dividends should according to Easterbrook (1984) be affected by unexpected changes in profits and we have therefore incorporated profits among the company selected factors that we are going to use in the research.
Another theory that explains the agency cost is the free cash flow theory by Jensen (1986). Jensen argues that the agency costs arise as the free cash flow increases. Because the shareholders have to increase the supervision in order to prevent the managers from engaging in excessive spending or unprofitable investments, such as empire building. This can be explained by the positive correlation between the size of the company and the enumeration plan of management (Murphy, 1985). The agency cost theory suggests that, dividend policy is determined by agency costs arising from the divergence of ownership and control. Managers may not always adopt a dividend policy that is value-maximizing for shareholders but would choose a dividend policy that maximizes their own private benefits. Making dividend payouts which reduces the free cash flows available to the managers would thus ensure that managers maximize shareholders' wealth rather than using the funds for their private benefits (DeAngelo et al., 2006
Life cycle theory:
This theory given by the Lease (2000) and Fama and French (2001) the finding of their research is that firms should follow a life cycle and reflect management's assessment of the importance of market imperfection and factors including taxes to equity holders, agency cost asymmetric information, floating cost and transaction costs. Miller and Scholes (1978) give the detailed explanation based on the effect of tax preferences on clientele and conclude different tax rates on dividends and capital gain lead to different clientele. Miller and Modigliani (1961) given the theory known as MM theory and clearly explained that in perfect markets, dividend
don't effect firms value. Shareholders are not concerned to receiving their cash flows as dividend or in shape of capital gain, as for as firm's doesn't change the investment policies. In this type of situation firm's dividend payout ratio effect their residual free cash flows and the result is when the free cash flow is positive firms decide to pay dividend and if negative firm's decide to issue shares. They also conclude that change in dividend may be conveying the information to the market about firm's future earnings.
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CONCLUSION
This study examined the agency cost theory, signaling theory, Bird in hand theory and MM proposition. The findings are that mangers are very unwilling to cut dividends once they are initiated. This unwillingness leads to dividends that are sticky, smoothed from year to year and tied to long run profitability of the firm. The results indicate that size, profitability, cash flow, growth and risk have an impact on the companies' dividend payout ratios. The size is the highly negative that show the firms invest in their assets rather than paying dividends to its shareholder. There was a positive relationship between dividends and profit and tax and negative relationship between dividends and growth. A negative relationship between systematic risk and earnings variability portray that higher the earnings variability lower will be dividend paid by the companies. The results also highlight that advertiser holding is positively related to dividend payout. The results also show that there is a negative relationship between growth and investment Opportunities and dividend payout ratio. However, some of the most successful companies during the last years such as Apple and Google have chosen not to pay dividend. This indicates that it is possible to be successful without paying dividends.
